2017 market outlook
by Andy Nasr, Vice-President, Capital Markets and Investment Strategist
Let’s be clear, finance professionals are inherently optimistic and biased. Opinions are largely shaped by information, intentions and incentives. One of the objectives of our asset allocation committee is to minimize bias and make decisions based on realistic, and not necessarily optimistic, expectations. We rely on a large and brilliant group of specialists who influence our asset allocation, risk-adjusted return expectations and outlook (as outlined below):
Favour developed vs. emerging markets
Overweight equities vs. fixed income
Political risk lingers
U.S. and Canadian equity market bias
U.S. earnings growth accelerates
U.S. fiscal policies: minimal impact in 2017
Increased fiscal vs. monetary stimulus
Interest rates increase modestly
Prefer corporate vs. sovereign credit
Global growth…the good, the bad and the “meh”
While we would love to be more optimistic, global growth is uninspiring, or as my niece often says when I ask her how she’s doing, “meh.”
But let’s start with the good. The global middle-income population is expected to double to five billion people within the next 20 years, with the vast majority of growth occurring in emerging markets. It’s an impressive number although the timing, give or take five years, is somewhat irrelevant. As incomes rise, household consumption increases and developing economies become more diversified, more productive and less dependent on the manufacturing sector (e.g., China). Multinational companies are already taking advantage of the anticipated growth. Approximately 40% of S&P 500 revenues are derived from international markets, which could increase to 50% during the next two decades.
Unfortunately, we anticipate the ongoing development of emerging economies will be less impactful than it has been historically. The world economy is excessively leveraged. Public and private market debt has exploded to more than 250% of GDP during the past decade, with a large increase in non-OECD countries. Since the 1960s, the global economy has been supported by population, employment and productivity growth, which will prospectively be slowed down by an aging workforce, rising dependency ratios and excessive debt. As witnessed during the financial and PIIGS* crises, exorbitant debt can become very problematic, which partially substantiates our preference for investing in developed markets rather than emerging markets.
A nod to equities vs. fixed income
With very few exceptions, we anticipate that central banks will maintain relatively accommodative monetary policies that may be supplemented by fiscal stimulus. Central bank liquidity is strongly correlated with global equity market returns. Moreover, global PMI’s and the spread between earnings and bond yields are supportive of overweighting equities vs. fixed income. Excluding the U.S., growth in many international economies remains dependent upon currency valuations that sustain trade competitiveness and an improvement in domestic demand supported by low interest rates, credit growth and fiscal spending. Accordingly, it’s difficult to picture a significant, sustainable and reflationary acceleration in global growth amidst a material increase in borrowing costs.
Fixed income: marginally higher rates and inflation
Fixed-income exposure should continue to provide investors with reasonable risk-adjusted returns, notwithstanding modestly higher interest rates and inflation expectations. Both investment-grade and high-yield bonds have outperformed government bonds during periods of rising rates. We have a preference for investment-grade corporates vs. sovereign debt and are selectively positioned in higher-quality non-investment-grade issuers. We believe that the U.S. 10-year Treasury yield will not eclipse 3.0% in 2017 and we may tactically use bond rallies to shorten duration. Importantly, we anticipate that relatively low borrowing costs should support debt serviceability and continue to encourage credit growth.
Overweight U.S. and Canadian equities
Negative interest rate policies in Europe and Japan have been disappointing, as lowering and anchoring borrowing costs have failed to materially improve spending, inflation or economic growth. Diminishing political risk and an improvement in domestic demand and operational leverage could justify an increased allocation to international equities as the year progresses. In the interim, we believe there’s superior earnings visibility underlying Canadian and U.S. equities.
Lest we be accused of familiarity bias, it’s worthwhile discussing U.S. equity market valuations in the context of history, interest rates and inflation. First and foremost, the most important determinant of long-term equity returns is earnings. When you invest in equities, you invest in companies. If those companies make more money, your investments should increase in value. The importance of long-term earnings growth is often complicated by a seemingly relentless and short-sighted fixation on multiples, perceived risk and volatility.
Real interest rates and inflation affect long-term capital costs, which influences the multiple investors are willing to ascribe to earnings. While we expect the U.S. economy to grow at a moderate pace, wage growth, a stronger U.S. dollar and a data-dependent/hawkish Federal Reserve will likely keep inflation from exceeding investor expectations and support equity valuations.
The elephant in the room: we’re “reform agnostic”
Business, consumer and investor sentiment have all soared since the U.S. election. Unfortunately, it’s difficult to assess the likelihood of optimism translating into stronger economic or earnings growth in the absence of policy clarity. Fiscal reform can be accomplished through budget reconciliation or Congress. While implementation will likely be deferred until the third quarter of 2017 at the earliest, we believe that investors will begin to discount the impact of the proposed changes once the budget is submitted in the first half of 2017. Importantly, our portfolios remain “reform agnostic” and we have not materially reoriented our positioning in anticipation of prospective policy changes.
Conclusion: diversification and active management can help mitigate volatility
Our asset allocation, portfolio construction and security selection are influenced by many factors, including a quantitative and qualitative assessment of expected risk-adjusted returns. The concept is straight forward. Given a choice between two investments with identical expected returns, investors will select the one that’s perceived to be less risky. When we articulate our outlook asset-allocation preferences, we’re reflecting risk-adjusted return expectations that are subject to change, and most importantly, are tactical. While we are currently overweight equities with a U.S. and Canadian bias, we continuously assess risk-adjusted return potential in various asset classes, regions and sectors. Having in-house specialists gives us an opportunity to maximize the benefits of diversification, mitigate risk and opportunistically allocate capital.
* Portugal, Italy, Ireland, Greece and Spain
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